Nifty Yet to find its Bottom, suggests the Bond Yields

Where is the bottom of the Market? The question has created a lot of buzz around us. Mulling over this question, I came across a few data that suggests, Nifty will take time to bottom out. The bond yields can give you a clear picture about it when you compare the movement of Bond Yields in 2008-09 to the 2020. We have also discussed the power of VIX in finding Bottom and Top of a market.

Last Friday evening, the Indian Government steeply revised its 2020-21 borrowing programme by 53.85% to Rs 12 lakh crore, from Rs 7.8 lakh crore estimated earlier. This means the GOI is giving shape to an imminent and sizeable fiscal package.

The above revision in borrowings has been necessitated on account of the COVID-19 pandemic,” the Reserve Bank of India (RBI) said in a statement on its website.

Between May 11 and September 30, the government will be borrowing Rs 6 trillion from the market. The original plan, as announced on March 31, was that in the first half (between April and September), the borrowing would be Rs 4.88 trillion, of which the government has already borrowed Rs 98,000 crore from the markets.

This indicates that stimulus measures are probably around the corner. The government has got resources from fuel excise, and now additional borrowing,” said Badrish Kulhalli, head of fixed income at HDFC Life Insurance.

The RBI will have to participate in OMOs in some way and keep the yield curve from jumping up. There will clearly be a pressure on yields and the RBI will have to manage it. It will involve expanded OMOs. RBI will now monetize the deficit by directly purchasing bonds from the government.

Every month there would be Rs 1.2 trillion of borrowing. Clearly, this is way above the market appetite. All kind of dated securities maturing in two years and above will be used, including floating rate bonds.

The bond yields had nosedived on Friday as the government introduced a new 10-year bond with a cut-off coupon of 5.79%. The old benchmark 10-year bond yield also dipped below 6% for the first time since February 2009. The benchmark 10-year bonds had closed at 5.97%, from its previous close of 6.05%.

From tomorrow, the bond yields will go up and bond prices will go down. So we need to understand the effect of rising bond yields on equity markets. Here we go:

Equity valuations are discounted on the Cost of Capital. First impact of rising bond yields on equities:

1. When bond yields rise, the yield on the bonds become more than the equity yield.
2. Investors and asset allocators may find debt relatively more attractive compared to equity in risk-adjusted terms.
3. When rates go up, the cost of debt goes up and the cost of capital goes up. 
4. This cost of capital is used to discount future cash flows to arrive at the valuation of companies. 
5. It means a higher cost of capital will depress the valuation of equities. That will be evident in the markets. 
6. This is more related to flows. When do foreign portfolio investors (FPIs) find it attractive to invest in India? Indian bond yields on 10-year benchmark are nearly 400-500 basis points higher than the US yields. 
7. The higher the yield spread, the more attractive Indian debt becomes for foreign bond investors. But, how does that impact equities? When FPIs pull out money from debt, it negatively impacts the INR as we saw in 2013 in a big way and in a much smaller way in 2016 and again in 2018.

There is a positive side also. It was observed by Russell Research that in the long run, higher yields are positive for equities as they imply higher inflation caused by higher growth.

If we talk about short term trend, whenever yields start rising after a correction in it means it had bottomed out and simultaneously the equity market will start to fall and within 3 to 4 months it will also start to go up. So meaning thereby that the equity has not bottomed yet and may fall further.

So be cautious and let's see how the market is reacting to this borrowing plan and when the GOI is coming with the stimulus package which the market has been waiting for since last 2 months…

The equity markets have normally moved negatively with bond yields. That means as bond yields go down, the equity markets tend to outperform and as bond yields go up, equity markets tend to underperform. This relationship may not exactly held in the very short run. But if you consider it for 5-10 years, this relationship will be clearly visible.

The equity markets have normally moved negatively with bond yields. That means as bond yields go down, the equity markets tend to outperform and as bond yields go up, equity markets tend to underperform. 

Nifty Vs Bond Yields (Credit: Bloomberg)

The above chart depicts the relationship between the Benchmark 10-Year GOI bond yield and the Benchmark Nifty50. Looking at the past 5 years since late 2012, the benchmark 10-year yields are down by almost (- 17 %) and have been moving consistently downtrend, despite occasional hiccups. At the same time, the Nifty is up by nearly 82%.

Bond yields impact foreign fund inflows

In a globalized world, investors are always looking for attractive yields across asset classes. Therefore, when bond yields in India seem to be more attractive than yields in other countries, there could be a lot of FII inflow into Indian bonds. If bond yields are attractive, there can be foreign outflow from Indian equities and inflows into Indian debt.

What determines bond yields?

Generally, bond yields are linked to the prevalent economic conditions. In deflationary environments, bond yields tend to be lower as more investors opt for investing in safer investment horizons. On the other hand, during the economic boom, bond yields tend to be higher as inflationary pressure leads to Central Bank raising interest rates and thus yields go up.

Stocks and bonds have an inverse relationship as when stock markets are up the bond markets are lower and vice versa. This behaviour prominently depicts an investor appetite for risk-reward. For example, when the stock market is going up, there is a lot more interest in the stock market due to the possibility of higher returns. Hence bond prices are lower.

At certain times both stocks and bonds can go up in value at the same time. This happens when there is too much money, or liquidity, chasing too few investments. It happens at the top of a market. It could also be the case when some investors are optimistic about the economy’s future, and buy stocks. 

At the same time, others are pessimistic and buy bonds instead. There are also times when stock and bonds both fall. That’s when investors are in a panic and are selling everything. During those times, the gold prices go up.

2008-09 Economy Crisis Vs 2020 Pandemic

From July 2008 to December 2008 the bond yields were constantly falling from 9.50% to 5.35% and the equity market were also falling from (Nifty) 4049 to 3050. 

Once the Bond Yields start rising in December 2008 (Shown with Up Arrow in the above image), the equity started again falling and went till the bottom it had made earlier in October 2008. 

After March 2009, the equity market started going up along with rising bond yields. Once the bond yields bottomed out then equity will be bottomed out.